Private equity's National City nightmare

A below-market deal could turn out to be less than a bargain if house prices keep falling.

(Fortune) -- Private equity is getting a nice chunk of National City for a song. But if house prices keep falling and foreclosures continue to rise, even Monday's steeply discounted
price tag may soon look dear.

Shares of the Cleveland-based bank tumbled 26% in trading Monday after National City (NCC,
Fortune 500) lined up a $7 billion capital infusion from investors led by Corsair Capital, a New York-based private equity firm. The deal, along with National City's decision to slash
its dividend for the second time this year, will bolster the bank's cushion against losses on its mortgage portfolio.

The agreement makes National City the third big U.S. bank this month to come hat in hand to the market, after similar deals at big mortgage lenders Washington Mutual (WM, Fortune 500) and Wachovia (WB, Fortune 500).

"We are pleased with the confidence that our investors have expressed in the value underlying National City's franchise and the fundamental strengths of our business model that will
help drive a return to profitability," CEO Peter Raskind said.

The deal's terms will help to protect the buyers - which include some of the bank's biggest institutional shareholders - against a further decline in National City's fortunes. The
bank agreed to sell the investing group 126 million common shares at $5 apiece and $6.4 billion worth of preferred shares that effectively will convert to common stock at the same
price. That 40% discount to Friday's closing price is steep even compared with the ones that prevailed at Washington Mutual (33%) and Wachovia (14%).

Yet some observers are wondering how smart National City's new private equity investors will feel looking back at this deal in a year or so. "There is much uncertainty about the
depth, breadth and timing of the credit downturn," former Wall Street executive Roger Ehrenberg writes at his Information Arbitrage blog. "With all of these unknowns, clearly the
investors in these deals are looking at the price they're paying and saying 'This is my margin of safety; I'm buying cheap.' But does anyone really have enough information yet to make
such an assessment?"

Like TPG, the private equity firm that led the $7 billion infusion at WaMu earlier this month, Corsair has deep roots in the banking industry. The firm was was part of JPMorgan Chase
(JPM, Fortune 500) before it was spun out of the giant bank back in 2005. The firm,
which has focused since its 1993 startup on financial services investments, is already emphasizing that it's not expecting a quick turnaround at National City.

"Our decision to make a long-term investment in National City reflects our recognition of the company's important role as a leading provider of core banking services to its many
customers," said Corsair Vice Chairman Richard E. Thornburgh, who is joining the National City board, "and our confidence in the potential of National City to achieve enhanced value
for its customers, stockholders and employees in the future."

Even so, there are reasons to wonder how even a recapitalized National City will fare in the coming year. For one thing, in-state rivals such as KeyCorp (KEY, Fortune 500) and Fifth Third (FITB, Fortune 500) - which could have benefited from the overlap between their own
retail banking operations and National City's - reportedly passed on the deal after taking a look at National City's books.

More tellingly, while house prices peaked in most of the U.S. in the summer of 2006, some industry players believe the banking sector is only beginning to feel the full brunt of
falling prices and other sour trends. Rival Bank of America (BAC, Fortune 500), for instance, on Monday posted a 77% drop in first-quarter
earnings, as its provision for credit losses soared to $6 billion from $1.2 billion a year ago. "We remain concerned about the health of the consumer," CEO Ken Lewis said, "given the
prolonged housing slump, subprime issues, employment levels and higher fuel and food prices."

Lewis isn't the only one making that point. Merrill Lynch (MER, Fortune 500) CEO John Thain made similar comments on Friday, as he addressed the
firm's brokers. "So far the slowdown has been finance-driven," Thain said, the New York Times' DealBook reported. "What we haven't seen yet is the impact on the consumer of falling
house prices, rising energy prices, higher food prices and higher unemployment."

National City may have an early view on those trends, given that it's based in economically-stricken northeast Ohio. At the end of the latest quarter, the bank's allowance for loan
losses - reflecting expected losses on residential real estate loans - was $2.6 billion, or 2.23% of the portfolio. That's double the year-ago level of 1.11%. National City said on
its conference call Monday that it expects $3 billion in losses on its home-equity and nonprime losses in the next year and a half.

National City's problems go well beyond the economic pain being felt in its Midwest base, however. Just a year ago, National City was putting new signs on scores of recently acquired
bank branches in Florida. The bank's $2.1 billion Sunshine State acquisition spree could hardly have come at a worse time: Florida ranked third nationally in foreclosure filings last
month, according to RealtyTrac.

To be sure, the trends won't keep running against banks like National City forever. Rising foreclosures have stoked a debate in Congress over measures that might ease the pain of the
housing bust on cash-strapped homeowners. Rep. Barney Frank has proposed a $300 billion Federal Housing Administration mortgage-guaranty program that could help hundreds of thousands
of homeowners refinance high-cost loans. Whatever shape an eventual federal action takes, it might be expected to slow the decline in house prices and therefore reduce the defaults
and delinquencies that leave big lenders nursing hefty loan losses.

But for now, legislators don't appear eager to undertake a costly homeowner-relief effort - which means that banks such as National City can expect to see house prices continuing to
fall and mortgage defaults rising. In all likelihood, says David Merkel, chief economist at broker-dealer Finacorp Securities, "We're still going to be facing this problem at this
time next year."